3 Ways to Use Covered Calls

Covered call strategies can be useful for generating profits in flat markets and, in some scenarios, they can provide higher returns with lower risk than their underlying investments, writes the staff at Investopedia.com.

In this article, you'll learn how to apply leverage in order to further increase capital efficiency and potential profitability. Three methods for implementing such a strategy are through the use of different types of securities: ETFs purchased on margin, index futures, and LEAPS.

While all of these methods have the same objective, the mechanics are very different, and each is better suited to a particular type of investor's requirements than the others.

Covered Call ReturnsCovered call strategies pair a long position with a short call option on the same security. The combination of the two positions can often result in higher returns and lower volatility than the underlying index itself.

For example, in a flat or falling market, the receipt of the covered call premium can reduce the effect of a negative return or even make it positive. And when the market is rising, the returns of the covered call strategy will typically lag behind those of the underlying index, but will still be positive. However, covered call strategies are not always as safe as they appear. Not only is the investor still exposed to market risk, but also the risk that over long periods the accumulated premiums may not be sufficient to cover the losses. This situation can occur when volatility remains low for a long period of time and then climbs suddenly.

Applying Leverage
Leveraged investing is the practice of investing with borrowed money in order to increase returns. The lower volatility of covered call strategy returns can make them a good basis for a leveraged investment strategy. For example, if a covered call strategy is expected to provide a 9% return, capital can be borrowed at 5% and the investor can maintain a leverage ratio of two times ($2 in assets for every $1 of equity); a 13% return would then be expected (2 × 9% - 1 × 5% = 13%). And if the annualized volatility of the underlying covered call strategy is 10%, then volatility of the two times leveraged investment would be twice that amount.

Of course, applying leverage only adds value when the underlying investment returns are significantly higher than the cost of the borrowed money. If the returns of a covered call strategy are only 1% or 2% higher, then applying two times leverage will only contribute 1% or 2% to the return but would increase the risk sharply.

Covered Calls in Margin Accounts
Margin accounts allow investors to purchase securities with borrowed money, and if an investor has both margin and options available in the same account, a leveraged covered call strategy can be implemented by purchasing a stock or ETF on margin and then selling monthly covered calls. However, there are some potential pitfalls. First, margin interest rates can vary widely. One broker may be willing to loan money at 5.5% while another charges 9.5%. As shown above, higher interest rates will cut profitability significantly.

Second, any investor who uses broker margin has to manage his or her risk carefully, as there is always the possibility that a decline in value in the underlying security can trigger a margin call and a forced sale. Margin calls occur when equity falls to 30-35% of the value of the account, which is equivalent to a maximum leverage ratio of about 3.0 times. (Note: margin = 100/leverage).

While most brokerage accounts allow investors to purchase securities on 50% margin, which equates to a leverage ratio of 2.0 times, at that point it would only take a roughly 25% loss to trigger a margin call. To avoid this danger, most investors would opt for lower leverage ratios; thus the practical limit may be only 1.6 times or 1.5 times, as at that level an investor could withstand a 40-50% loss before getting a margin call.

Covered Calls with Index Futures
A futures contract provides the opportunity to purchase a security for a set price in the future, and that price incorporates a cost of capital equal to the broker call rate minus the dividend yield.

Futures are securities that are primarily designed for institutional investors but are increasingly becoming available to retail investors.

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As a futures contract is a leveraged long investment with a favorable cost of capital, it can be used as the basis of a covered call strategy. The investor purchases an index future and then sells the equivalent number of monthly call-option contracts on the same index. The nature of the transaction allows the broker to use the long futures contracts as security for the covered calls.

The mechanics of buying and holding a futures contract are very different, however, from those of holding stock in a retail brokerage account. Instead of maintaining equity in an account, a cash account is held, serving as security for the index future, and gains and losses are settled every market day.

The benefit is a higher leverage ratio, often as high as 20 times for broad indexes, which creates tremendous capital efficiency. The burden is on the investor, however, to ensure that he or she maintains sufficient margin to hold his or her positions, especially in periods of high market risk.

Because futures contracts are designed for institutional investors, the dollar amounts associated with them are high. For example, if the S&P 500 index trades at 1400 and a futures contract on the index corresponds to 250 times the value of the index, then each contract is the equivalent of a $350,000 leveraged investment. For some indexes, including the S&P 500 and Nasdaq, mini contracts are available at smaller sizes.

LEAPS Covered Calls
Another option is to use a LEAPS call option as security for the covered call. A LEAPS option is an option with more than nine months to its expiration date. The LEAPS call is purchased on the underlying security, and short calls are sold every month and bought back immediately prior to their expiration dates. At this point, the next monthly sale is initiated and the process repeats itself until the expiration of the LEAPS position.

The cost of the LEAPS option is, like any option, determined by:

The Intrinsic Value

the Interest Rate

the Amount of Time to Its Expiration Date

the Estimated Long-Term Volatility of the Security

Even though LEAPS call options can be expensive, due to their high time value, the cost is typically less than purchasing the underlying security on margin.

Because the goal of the investor is to minimize time decay, the LEAPS call option is generally purchased deep in the money, and this requires some cash margin to be maintained in order to hold the position. For example if the S&P 500 ETF is trading at $130, a two-year LEAPS call option with a strike price of $100 would be purchased and a $30 cash margin held, and then a one-month call sold with a strike price of $130, i.e., at the money.

By selling the LEAPS call option at its expiration date, the investor can expect to capture the appreciation of the underlying security during the holding period (two years, in the above example), less any interest expenses or hedging costs. Still, any investor holding a LEAPS option should be aware that its value could fluctuate significantly from this estimate due to changes in volatility.

Also, if during the next month the index suddenly gains $15, the short call option will have to be bought back before its expiration date so that another can be written. In addition, the cash margin requirements will also increase by $15. The unpredictable timing of cash flows can make implementing a covered call strategy with LEAPS complex, especially in volatile markets.

The Bottom Line
Leveraged covered call strategies can be used to pull profits from an investment if two conditions are met:

The level of implied volatility priced into the call options must be sufficient to account for potential losses.

The returns of the underlying covered call strategy must be higher than the cost of borrowed capital.

A retail investor can implement a leveraged covered call strategy in a standard broker margin account, assuming the margin interest rate is low enough to generate profits and a low leverage ratio is maintained to avoid margin calls. For institutional investors, futures contracts are the preferred choice, as they provide higher leverage, low interest rates and larger contract sizes.

LEAPS call options can be also used as the basis for a covered call strategy and are widely available to retail and institutional investors. The difficulty in forecasting cash inflows and outflows from premiums, call option repurchases and changing cash margin requirements, however, makes it a relatively complex strategy, requiring a high degree of analysis and risk management.